Liquidity and Expected Returns in a Multi-Factor Asset Pricing Model

In this paper I show how the price impact of trading afiects the cross-section of expected returns. I analyze a market with a large number of assets, risk avers investors and asymmetric information about flrm speciflc components of future div- idends. If there are no frictions then price impact is irrelevant for expected returns. If some investors are not able to short-sell then the factors that determine the div- idends of illiquid assets carry a higher risk premium than comparable factors that determine the dividends of liquid assets. Liquidity is not a source of systematic risk beyond the systematic dividend risk factors.